CFA Level III: Interest Rate Parity

Today I’m gonna talk about some economic concepts that were mentioned at least since Level II and that are quite useful in the whole curriculum and in finance in general when it comes to dealing with currency management.

Covered Interest Rate Parity

The idea is quite simple, we will compute the forward exchange rate between two currencies using an arbitrage argument, say EUR and USD. The spot exchange rate is denoted $S_{\text{EUR}/\text{USD}}$: it corresponds to the number of euros you get today for 1 US dollar. Furthermore, the risk-free rate in USD is denoted $R_{\text{USD}}$ and the risk-free rate in EUR is denoted $R_{\text{EUR}}$. The question is, after some time $T$, how many euros will I get for 1 US dollar? This rate is called the forward rate and is denoted $F_{\text{EUR}/\text{USD}}$.

Well, you can price that quite easily using an arbitrage argument! The idea is simple:

I’m going to borrow today $\frac{1}{1+R_\text{USD}}$ USD which means that at time $T$, I will have to pay back 1 USD.

Then I’m going to convert what I just borrowed in EUR, which gives me $S_{\text{EUR}/\text{USD}} \cdot \frac{1}{1+R_\text{USD}}$ euros

I then invest this at the risk-free rate in EUR, and I get at time $T$ $(1+R_\text{EUR}) S_{\text{EUR}/\text{USD}} \cdot \frac{1}{1+R_\text{USD}}$ euros

This is very useful because you very often have to say what currency is trading at premium or at discount in another currency. First I used to always get that wrong. In fact, it’s very easy. The currency being traded is the one in the denominator of the label, here USD. Then, if the forward price is higher (lower) than the spot price, it is of course trading at premium (discount).

So, if we say that the USD is trading at premium in EUR, it means that we can have more EUR in the forward market than in the spot market for 1 USD.

Uncovered interest rate parity

This is in a sense an extension of the covered interest rate parity we just discussed which says that:

Notice that here the implication is different than previously, because we say that we expect that the spot rate at time $T$ will be equal to the forward price at today. This comes to says that the currency that has the higher (lower) interest rate is expected to depreciate (appreciate):

Indeed, a higher spot rate in the future means that you would get more euros for the same amount of US dollars which means that the euro has depreciated!

A lot of traders disagree with that statement, and this comes to a very famous trading strategy called the carry trade. The idea is really simple as well: these traders do not think that the currency with the higher interest rate will depreciate. They hence short the currency with lower interest rate and invest in the currency with higher interest rate. In the curriculum, they say that this strategy tends to work most of the time, generating positive income. However, they say that, when for some reason, the interest rate goes in the expected direction, they tend to do so very violently and that it can lead to very large losses.

That’s it for today, I hope this little post will help you in mastering this concept, which is key to a lot of different topics at different levels of the CFA curriculum.